Ancient Chinese merchants are said to have developed a unique way to reduce their risk. They would divide their shipments among several different vessels. That way, if one ship were to sink or be attacked by pirates, the rest stood a good chance of getting through and the majority of the shipment could be saved.
Your investment portfolio may benefit from that same logic.
Diversification is an investment principle designed to manage risk. However, diversification does not guarantee against a loss. The key to diversification is to identify investments that may perform differently under various market conditions.
On one level, a diversified portfolio should be diversified between asset classes, such as stocks, bonds, and cash alternatives. On another level, a diversified portfolio also should be diversified within asset classes, such as a diverse basket of stocks.
A Diversified Approach
For example, say a stock portfolio included a computer company, a software developer, and an internet service provider. Although the portfolio has spread its risk among three companies, it may not be considered well diversified since all the firms are connected to the technology industry. A portfolio that includes a computer company, a drug manufacturer, and an oil service firm may be considered more diversified.
Similarly, a bond portfolio that invests exclusively in long-term U.S. Treasuries may have limited diversification. A bond fund that invests in short- and long-term U.S. Treasuries as well as a variety of corporate bonds may offer more diversification.
Mutual Funds and ETFs
The concept of diversification is one reason why mutual funds and Exchange Traded Funds (ETFs) are so popular among investors. Mutual funds accumulate a pool of money that is invested to pursue the objectives stated in the fund’s prospectus. The fund may have a narrow objective, such as the auto sector, or it may have a broader objective, such as large-cap stocks. ETFs also can have a narrow or broader investment objective. Keep in mind, however, the more narrow an investment objective, the more limited the diversification.
The concept of diversification is critical to understand when you are evaluating a portfolio. If you want more information on diversification, or have questions about how your money is invested, please call so we can review your situation. Shares, when redeemed, may be worth more or less than their original cost.
Mutual funds and exchange-traded funds are sold only by prospectus. Please consider the charges, risks, expenses, and investment objectives carefully before investing. A prospectus containing this and other information about the investment company can be obtained from your financial professional. Read it carefully before you invest or send money.
Tip: Correlation. To adequately diversify, it’s important to select securities that have a low correlation — that is, securities that don’t tend to track each other’s movements up and down. Securities with a high correlation may tend to fail together — defeating the purpose of diversification.
Source: Investopedia, 2018
Fast Fact: Only One? One landmark study of more than 40,000 equity investment accounts found that about 25% of accounts held only one stock, and about half held only one or two stocks.
Source: National Bureau of Economic Research, 2001
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